“ANALYSIS OF DOMESTIC DEBT ON THE INDIAN

ECONOMY”

A Project submitted in partial fulfilment of the course ECONOMICS-I, 3rd

SEMESTER during the Academic Year 2019-2020

SUBMITTED BY:

AESHNA RAGHUWANSHI

Roll No. – 1911

B.A. LL.B(Hons.)

SUBMITTED TO:

DR. SHIVANI MOHAN

FACULTY OF ECONOMICS-I

ACADEMIC YEAR- 2019-20

CHANAKYA NATIONAL LAW UNIVERSITY, NAYAYA NAGAR,

MEETHAPUR, PATNA-800001

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 DECLARATION BY THE CANDIDATE

I hereby declare that the work reported in the B.A.LL.B (Hons.) Project Report Entitled
“ANALYSIS OF DOMESTIC DEBT ON THE INDIAN ECONOMY” submitted at
Chanakya National Law University, Patna is an authentic record of my work carried out
under the supervision of Dr. Shivani Mohan. I have not submitted this work elsewhere for
any other degree or diploma. I am fully responsible for the contents of my Project Report.

(Signature of the Candidate)

AESHNA RAGHUWANSHI
Chanakya National Law University, Patna

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 ACKNOWLEDGEMENT

Firstly, I would like to thank my faculty of ECONOMICS-I, Dr. Shivani Mohan for
providing me an opportunity to make my project on such an interesting topic which is also a
contemporary issue as for now.
Secondly, I would like to thank all my colleagues and friends for helping me out in arranging
of the accumulated collected study material.
Lastly, special thanks to my parents for guiding me in giving the final touch to this project
and helping me out throughout this project.

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 Table of Contents

ACKNOWLEDGEMENT...........................................................................................................................3

INTRODUCTION.....................................................................................................................................5

OBJECTIVES............................................................................................................................................6

LIMITATION OF THE STUDY...................................................................................................................7

1. DOMESTIC DEBT: DEFINITIONS AND MEANING.............................................................................8

2. TRENDS OF DOMESTIC DEBT........................................................................................................10

3. IMPACT OF DOMESTIC DEBT ON ECONOMIC GROWTH...............................................................12

4.REFORMS OF CAPITAL MARKET IN INDIA.........................................................................................14

5. CONCLUSION, CRITICISM AND SUGGESTION...................................................................................16

BIBLIOGRAPHY.....................................................................................................................................17

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 INTRODUCTION

Management of public debt is a worldwide test being looked by the administrations of many
creating and created nations. The macroeconomic impacts of open obligation have
consistently been a discussed issue in the writing. India has tirelessly confronted a high
proportion of open obligation to GDP during the previous decades, which is far higher than
the distinctive Finance Commissions' long haul focus of obligation to GDP proportion
(beneath 60 percent). This rising pattern has for the most part been joined by an extension in
the size of governments. Tirelessness of high obligation to GDP proportion suggests that
open obligation, particularly household obligation, has turned into significant methods for
money related assets preparation of the Indian Government to meet its developing use needs.
In India, household obligation makes up almost 95 percent of the total open obligation, while
outside obligation comprises a next to no partake in complete open obligation. The burden of
public debt depends on how the funds, mobilized through public debt, are used. If public debt
is wasted on relatively unproductive activities (like financing current expenditure), it
becomes a dead weight due to its adverse effects on capital accumulation, as well as
productivity.3 Hence, it reduces economic growth. On the other hand, if the resources raised
by the Government through borrowings are spent on developmental activities like capital
formation, they raise the productive capacity of the country. Thus, they are not burdensome.4
An important channel through which the accumulation of public debt can affect economic
growth is that of long-term interest rates. Higher long-term interest rates, resulting from more
debt-financed Government budget deficits, can crowd out private investment, thus dampening
potential output growth. A large public debt might create debt overhang, a situation in which
investment is reduced or postponed since the private sector anticipates that the returns from
their investment will serve to pay back creditors.1

The recent switch from external to domestic borrowing may just lead countries to trade one
type of vulnerability for another. For instance, countries that are switching from external to
domestic debt could be trading a currency mismatch for a maturity mismatch. Alternatively,
the switch to domestic borrowing could lead to pressure on institutional investors and banks
to absorb “too much” government debt and this may have a negative effect on financial
stability. Moreover, expanding the market for domestic government bonds may have positive
1
https://commodity.com/debt-clock/india/

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externalities for the domestic corporate bond market but there is also the risk that the public
sector may crowd out private issuers. Finally, there are political economy reasons that may
make domestic debt more difficult to restructure. In fact, a few highly indebted countries
which were able to use debt relief initiatives to address their external debt problems are still
burdened with high levels of domestic debt. It is also important to correctly evaluate the cost
of borrowing in different currencies. In an environment in which several emerging currencies
are expected to appreciate vis-à-vis the United States dollar, the ex post interest rate in
domestic currency may end up being higher than that in dollar.

OBJECTIVES
1. To know about the Indian economic system.
2. To know about the vulnerabilities of external debt or domestic debt.

RESEARCH METHODOLOGY
The researcher has adopted the doctrinal method of the research.

SOURCES OF DATA
In order to complete the research study, the researcher will collect the material through
various primary and secondary sources of data.

PRIMARY SOURCES such as books, documents, datas and stats.

SECONDARY SOURCES reviewing the internet and different websites which preserve
documents and put them up for knowledge distribution.

HYPOTHESIS

1. The researcher presumes that domestic debt affect the economic growth.
2. The researcher presumes that domestic debt results in inflation.

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LIMITATION OF THE STUDY

Since the researcher is a student of law, she has access to a limited area and knowledge. The
researcher having only a preliminary knowledge of the subject could understand the problem
clearly but was faced with constraints.

However, the researcher only has access to limited amount of work that is available in the
library. The researcher has a restricted access to information and sources for reasons beyond
her control. But the researcher will still attempt to take out the best possible.

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 1. DOMESTIC DEBT: DEFINITIONS AND MEANING

There are three definitions of domestic debt. The first focuses on the currency in which the
debt is issued (with external debt defined as foreign currency debt). The second focuses on
the residence of the creditor (external debt is debt owed to non-residents). The third focuses
on the place of issuance and the legislation that regulates the debt contract (external debt is
debt issued in foreign countries and under the jurisdiction of a foreign court).

The first definition does not seem appropriate because several countries issue foreign
currency denominated debt in the domestic markets and have recently started to issue
domestic currency denominated debt in international markets. Moreover, this definition is
problematic for countries that adopt the currency of another country. 2Finally, a definition
based on the currency composition of public debt would be hard to implement given the
limited information on the currency composition of domestic debt.4 This does not mean that
countries should not report information on the currency composition of their external debt. In
fact, such information is a key factor for evaluating a country’s vulnerability to currency
mismatches and potential responses to a debt crisis. However, currency composition should
not be confused with the definition of external debt.

The second definition is the one which is officially adopted by the main compilers of
statistical information on public debt. The External Debt Statistics: Guide for Compilers and
Users jointly published by the BIS, Eurostat, IMF, OECD, Paris Club, UNCTAD and the
World Bank states that: “Gross external debt, at any given time, is the outstanding amount of
those actual current, and not contingent, liabilities that require payment(s) of principal and/or
interest by the debtor at some point(s) in the future and that are owed to non-residents by
residents of an economy”. This definition makes sense from a theoretical point of view
because it focuses on the transfer of resources between residents and non-residents; it allows
to measure the amount of international risk sharing and the income effects of variations in the
stock of debt, and to evaluate the political cost of a default on public debt. However, this
definition is almost impossible to apply in the current environment where most external debt
due to private creditors takes the form of bonds (things were easier when most external debt
owed to private creditors was channelled through syndicated bank loans). Of course,

2
https://bizfluent.com/facts-6828714-definition-domestic-debt.html

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countries could try to identify the residence of whoever bought the bonds in the primary
market and track what happens in the secondary market by running periodical surveys.
However, few developing countries are attempting (or have the capacity) to identify the
ultimate holders of their bonds.5 Even those that try to do so cannot do anything for bonds
held in offshore financial centres. As a consequence, most countries end up reporting figures
for external and domestic debt by using information on the place of issuance and jurisdiction
that regulates the debt contract. This is not a problem, per se (in fact, it is exactly what I
suggest below), the problem is that the information is misleading because it does not measure
what it promises to do (i.e., transfer of resources from non-residents to residents).3

As a consequence, a third definition came, which classifies as external all debt issued under
foreign law (this is the definition used in CLYPS). While the second definition is the one
which is theoretically correct, a definition based on jurisdiction is feasible and does not give
misleading information on who are the supposed holders of a country’s debt. Take for
instance the definitions of external and domestic debt used in this paper. This is a significant
source of confusion. 4

3
https://www.focus-economics.com/economic-indicator/public-debt
4
ibid

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 2. TRENDS OF DOMESTIC DEBT

Domestic public debt is not a new phenomenon for developing countries. The increase in
domestic debt was mainly due to new borrowing and that of external debt was due to
accumulation of arrears. This suggests that if emerging market countries had not been shut
down from the international capital market, they would have probably accumulated more
external and less domestic debt. Low income countries have a tradition of domestic
borrowing (in his sample of sub-Saharan African countries, domestic public debt was about
10 per cent of GDP in 1980). Most of the domestic debt issued by low income sub-Saharan
African countries is held by commercial banks and has short maturity (average maturity is ten
months and the majority of bonds have a 3-month maturity). In a study of 17 West African
countries, Beaugrand, Loko and Mlachila (2002) found that most medium term debt was not
issued at market conditions and consisted of securitization of arrears. However, they found
that Mali, Benin, and Senegal did place some medium term bonds at market rates. Abbas
(2007) and Abbas and Christensen (2007) show that bank-holdings of domestic public debt in
low income countries were about 5.5 per cent of GDP in the 1975-1985 period and increased
to 8.4 per cent of GDP in the 1996-2004 period. The increase was particularly large in
emerging market countries, where bank-holdings of public debt went from 7.8 to 14.3 per
cent of GDP. As in the case of emerging market countries, also in low income countries
external factors are among the main drivers of the accumulation of domestic public debt
which, somewhat paradoxically, can be driven by either too little foreign aid or too much
foreign aid.8 Countries that run a budget deficit which is not fully matched by donor flows
often issue domestic debt because the standard policy advice of the international financial
institutions is to limit external borrowing at commercial rate. In fact, for countries that have
an IMF programme, there are explicit limits on external borrowing at commercial rate.5

Build ups of domestic debt driven by excessive foreign aid are also possible and frequent. In
order to understand how this can happen, it is useful to classify what a country can do with
aid flows. It can: (i) absorb and spend the aid flows; (ii) not absorb and not spend the aid
flows; (iii) absorb but not spend; and (iv) spend and not absorb.10 In the first case, the

5
http://shodhganga.inflibnet.ac.in/bitstream/10603/21796/9/09_chapter%203.pdf

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government spends all the aid flows by buying either foreign or domestic goods. This results
in no net accumulation of assets or liabilities and often leads to an appreciation of the real
exchange rate. In the second case, all aid is transformed into international reserves. This
contributes to reserve build up and increases the net wealth of the beneficiary country but has
no other effect on the economy. In fact, if one excludes the reserve build up, this strategy is
equivalent to not receiving aid. In the third case, the government uses the aid flows to reduce
its deficit without changing its expenditure and hence reduces its public debt. In the fourth
case, the government widens its budget deficit but does not use the external aid flows (that
remain locked in the central banks in form of international reserves). This is equivalent to a
fiscal expansion in absence of aid and may be driven by the government’s decision of
sterilizing aid inflows. A government that decides to spend and not absorb can either print
money or issue domestic debt. It is in this sense that aid can translate into an increase of
domestic debt. While this latter policy may look like an odd choice, case studies show that
this is not an infrequent strategy among countries that are attempting to avoid an appreciation
of the real exchange rate (Aiyar, Berg and Hussain, 2005).6

6
ibid

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 3. IMPACT OF DOMESTIC DEBT ON ECONOMIC
GROWTH

Recent studies dealing with nexus between external debt and growth found that, the
relationship between the two could be non-linear (inverted-U type shape). This means there
could be threshold limit up to which debt can induce growth and thereafter higher debt can
reduce growth. The threshold limit of external debt is estimated to be 38.4 percent of GDP by
Smyth and Hsing (1995); 21 percent by Blavvy (2006); 85 percent by Cecchetti et al. (2011);
90-100 percent by ChecheritaWestphal and Rother (2012); and 90 percent by Chen et al.
(2016). On the other hand the study by Reinhart and Rogoff (2010) concludes that in
advanced and emerging market economies (EMEs), debt to GDP ratio of about 90 percent is
growth reducing. If the ratio is below 60 percent then it can retard economic growth in only
EMEs. Subsequently, Herndon et al. (2013) try to replicate the study by Reinhart and Rogoff
(2010). By making some correction they find that the relationship between debt ratio and
economic growth is similar in the two situations. So far as causality between public debt and
economic growth is concerned, Panizza and Presbitero (2014) do not find any causality
between the two, whereas Puente-Ajovín and Sanso-Navarro get bi-directional causality
between public debt and economic growth. Lof and Malinen (2014) get support of one way
causality from growth to debt.7

It is well known that financial deepening results in higher growth through different channels
like more credit with financial liberalization promotes investment and innovation resulting in
more efficient investment and thereby growth. In the literature various studies are done to
explore the relationship between financial development and economic growth. 3 One strand
of studies including Goldsmith (1969), focuses to measure the strength of the relationship
between the financial development and economic performance. Others try to identify the
channels through which the two are related. Pioneering work of McKinnon (1973) and Shaw
(1973) reflects that financial liberalization positively affects saving and therefore more
investment culminating in higher economic growth. Later on various papers using the
endogenous growth models take financial development as a physical capital generating
technological progress and increasing the efficiency in investment (See Bencivenga and
Smith, 1991; Greenwood and Jovanovic, 1990). But not all economists are convinced with
7
https://pdfs.semanticscholar.org/5b9d/5c976bce4de1f4c7e6c1fc9dd2eae6a39c04.pdf

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the role of credit in generating growth. Robinson (1952) states that ‘where enterprise leads,
finance follows’ which means economic growth creates the condition of financial
arrangement and thereby financial development. Lucas (1988) is of the view that the role of
financial development in growth is ‘over stressed’.8

Economic growth in a
modern economy hinges on
an efficient financial sector
that pools
domestic savings and
mobilizes foreign capital for
productive investments.
Underdeveloped or poorly
functioning capital markets
typically are illiquid and
expensive which deters
foreign investors.

8
ibid

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Furthermore, illiquid and
high transactions costs also
hinder the capital raising
efforts of lager
domestic enterprises and may
push them to foreign markets.
Recent theoretical literature on
financial development and
growth identifies three
fundamental
channels through which
capital markets and
economic growth may be
linked (Pagano, 1993): First,
capital market development
increases the proportion of
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savings that is funnelled to
investments;
Second, capital market
development may change the
savings rate and hence, affect
investments; Third,
capital market development
increases the efficiency of
capital allocation. In
compliance to these
channels, introducing an
efficient capital market to
link between the net savers
(households) and net
investors (entrepreneurs)
results in reduction of
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transactions costs associated
with funnelling savings,
making the household
savings highly liquid,
enabling selection of
efficient investments by
gathering
information on investment
returns efficiently, and
providing markets for
diversification of risks by
households and corporate.
If the capital markets are not
efficient, the public offering
largely disappears as a result
of high
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transaction costs or the
uncertainty of getting a fair
price in the stock market.
Thus, inefficient capital
markets may reduce the
incentive to enter new
ventures, reducing overall
long-term productivity of the
economy. On the other
hand, an efficient capital
market reduces the
transaction costs of trading
the
ownership of the physical
assets and thereby paves the

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way for the emergence of an
optimal ownership
structure.
Thus, efficient and liquid
capital markets provide
avenues for the effective
utilization of funds
for long-term investment
purposes by mobilizing them
from the surplus spending
economic units to the
deficit spending economic
units (Ekineh, 1996). In
short, an efficient capital
market is essential for

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long-term growth in capital
formation (Osaze, 2000).
Ekundayo (2002) argues that a
nation requires a
lot of local and foreign
investments to attain
sustainable economic growth
and development. The
capital market provides a
means through which this is
made possible. In addition,
capital markets
provide the opportunities for
the purchase and sale of
existing securities among
investors thereby
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encouraging the populace to
invest in securities and
fostering economic growth
(Ewah, et al 2009).
Therefore, efficiently
functioning capital market
affects liquidity, acquisition
of information
about firms, risk
diversification, savings
mobilization and corporate
control (Anyanwu 1998).
Hence,
by altering the quality of these
services, the functioning of

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stock markets can alter the
rate of economic
growth (Equakun 2005).

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 4.REFORMS OF CAPITAL MARKET IN INDIA

Broadly speaking, long-term domestic currency debt reduces maturity and currency
mismatches and hence tends to be safer (from the borrower’s point of view) than short-term
foreign currency debt. This is important for the choice between external and domestic
borrowing because most developing countries are unable to issue domestic currency debt
(either short or long-term) in the international market (Eichengreen, Hausmann and Panizza,
2005a). However, while most emerging market countries do issue domestic currency bonds in
their own market, few of them are able to issue longterm domestic debt at a reasonable
interest rate, those that cannot may face a trade-off between a maturity and a currency
mismatch. It is not clear what types of policies are necessary to escape this potential trade-
off. While most analysts agree that a recent history of low inflation and macroeconomic
stability is key for a country’s ability to issue domestic long dated bonds in its own currency
(Hausmann and Panizza, 2003; Mehl and Reynaud, 2005; and Jeanne and Guscina, 2006),
there is less agreement on the potential role of other policy variables including the presence
of capital controls, the role of domestic institutional investors, and the participation of foreign
investors on the domestic market.9

While Hausmann and Panizza (2003) suggest that the presence of capital controls is
positively associated with a country’s ability to issue domestic long dated bonds in its own
currency, Mehl and Reynaud (2005) find that this result is not robust to using a larger sample
of countries. The behaviour of individual countries also yields mixed signals. The presence of
capital controls has been a key factor for India’s ability to finance large budget deficits by
issuing long dated bonds in domestic currency (in 2006, the average maturity of Indian
domestic government bonds was 16.9 years, Gopinath, 2007). However, Mexico recently
issued domestic currency bonds with 20-year maturity without needing any sort of capital
controls. The difference is that the majority of Indian government bonds are bought by
domestic investors (mainly banks) and most of Mexico’s long dated bonds are bought by
foreign investors (Castellanos and Martinez, 2006) who are desperately looking for yield in
an environment characterized by low interest rates and vast liquidity.10

9
http://data.conferenceworld.in/25FebEMSSH/25.pdf
10
ibid

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Policies aimed at promoting the entry of foreign investors in the domestic market are also
controversial. Supporters argue that the presence of foreign investors can help in expanding
market size and, by increasing the net flows of external resources into the country, limit
crowding out. In this sense, having a large presence of foreign investors in the domestic
market is equivalent to being able to issue domestic currency debt in the international market.
However, policies aimed at promoting the presence of foreign investors may result in a loss
of policy space. For instance, such policies are often incompatible with the presence of
capital controls and with a country’s ability to manage its exchange rate. Moreover, policies
aimed at attracting foreign investors may result in sudden inflows of “hot money” and thus
lead to high capital flow volatility and financial instability.11

11
https://shodhganga.inflibnet.ac.in/bitstream/10603/13010/11/11_chapter%204.pdf

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 5. CONCLUSION, CRITICISM AND SUGGESTION

The traditional dichotomy between external and domestic debt does not make much sense in
a world characterized by open capital accounts and that, although the recent switch to
domestic borrowing has important positive implications for debt management, policymakers
should not be too complacent.

Crisis prevention requires detailed and prompt information on debt structure. Yet, most
research and analysis focuses on external borrowing and prompt and detailed information on
the level and composition of domestic public debt is often not available to policymakers and
analysts. This situation is made even worse by the fact that standard debt sustainability
analyses of public debt use a definition of “external” debt which does not reflect what it is
supposed to measure.

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 BIBLIOGRAPHY

BOOKS REFERRED

 K Viswanathan, International Banking

 L M Bhole, Financial Markets And Instruments
 Apte, International Finance
 Gordan & Natrajan, Financial Markets And Services

ARTICLES

 Capital Markets and NSDL-Overview National - Handbook for NSDL Depository

Operations Module

 Capital market and securities laws (module ii paper 6)

WEBSITE REFFERED
 http://www.google.com
 http://www.wikipedia.com
 www.imf.com

 www.sbimf.com
 www.moneycontrol.com
 www.amfiindia.com
 www.onlineresearchonline.com
 www.mutualfundsindia.com
 www.sebi.gov.in
 www.rbi.gov.in
 www.investopedia.com

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